The term ‘purchase option’, also sometimes referred to as a ‘lease option’ might seem technical – but don’t let that fool you. They refer to simple concepts, albeit ones which require a certain amount of experience and detail to explain. Here, we explain exactly what it means, along with the pros, cons, and alternatives.
It’s almost always preferable to buy a property outright than to make use of an option, but sometimes the former pathway is cut off. It may be that the vendor doesn’t want to sell, or can’t for some reason or other. It may be that they know that their investment is sure to be more valuable in a few years’ time, and that they’d prefer to delay a sale and thereby secure a better return. Clearly, this creates a dilemma between what the purchaser wants and what the vendor wants.
Happily, there’s a way of resolving this dilemma, and creating a win-win situation for both parties: an option. This provides control over a property without ownership of it. The property can be purchased at a future date, and the vendor can switch their attention to another property, and the purchaser can get control of the property and generate cash-flow from it.
What Are Lease Options in Property?
A lease option allows the purchaser to control the property, and thereby make money from it, while agreeing to abide by certain pre-agreed obligations. A lease option doesn’t require huge resources, and so they’re a great way to get started with property investment. You generate a monthly income from the property, gradually building up capital.
Eventually, you might come to exercise an option to purchase the property at some future date. In this case, the intervening period acts as a transition between the two states, providing a flexible solution for those looking to generate income from property who don’t have the luxury of a sizeable cash reserve to draw upon.
Lease options come in several different sorts. The two most often-cited are rent-to-buy and owner financing. These two strategies differ in some respects, while being broadly identical in others. Let’s take a look at them.
Lease Options or Owner Financing
With this approach, the property’s owner finances the buyer. They are, in effect, acting like a bank, lending the buyer the money to buy the home. What sets owner financing apart from options is that it allows the buyer to legally own the home outright – even if they’re indebted to the seller after doing so.
As with a traditional mortgage, both lending and borrowing parties sign a legal agreement stipulating the terms of the deal. For couples with poor credit ratings who can’t secure financing elsewhere, this is an attractive option. It’s a way to move straight in without waiting for approval from the bank. It’s a risky one for the seller, however; if the buyer can’t pay the debt, then the owner will need to foreclose. This will make it necessary to find another buyer, and it’ll also incur legal fees. The owner will need to vet the buyer closely to avoid being stung – and those buyers who can demonstrate their reliability will typically be able to get a loan elsewhere, making owner financing unnecessary.
Lease Options or Rent to Own
In a ‘rent-to-own’ arrangement, the tenant is looking to slowly transition from renting the property to owning it in the long term. They agree at the outset to buy the home within a certain timeframe, typically more than a year after the agreement is made. The prospective purchaser will occupy the property under a normal Assured Shorthold Tenancy (AST) arrangement. They’ll pay an additional sum on top of the rent each month, in order to buy down the cost of the property over time, and ultimately come to own it. They’ll also likely have to pay a sum upfront. In most cases, the ultimate price of the property will be agreed-upon in advance – but this is not always the case.
The key advantage of rent-to-own, as far as the tenant is concerned, is that it makes transitioning from being a tenant to an owner much more smooth. There’s no need to secure a large amount of capital, and the tenant doesn’t have to go through a move when they do get the money together. Moreover, while the tenant is renting, they’re effectively testing the property to find out whether it’s a good match for them in the long-term.
Of course, this is a strategy whose reputation has taken something of a battering in recent years. The market for rent-to-own is barely regulated, and so unscrupulous (or incompetent) investors are able to pull the rug from under their hapless tenants at a moment’s notice.
It’s an approach which would-be buyers will be justifiably wary of, as they’ll often find themselves unprotected when things go wrong. But the seller also carries risk: since the title and the mortgage remain in their name, it’s them who’ll be pursued for payment should things go wrong.
If you’re an ethical investor, on the other hand, rent-to-own schemes represent a great way to get people onto the housing ladder without having to incur a sizeable deposit. It’s an attractive option for people with a healthy revenue, but who lack the capital to purchase a home.
Ultimately, your success or failure when it comes to lease options will hinge on your judgement of your own finances, and those of the person you’re working with. If you think that you’ll be able to generate enough cashflow to cover the cost of repayment, then a lease option might allow you to make significant investment with little capital expenditure. Of course, if you can’t, then you’ll create a headache for yourself when payments can’t be made. It’s in the interest of both selling and buying parties, therefore, to ensure that such headaches are unlikely.
If you’re looking to learn more about lease ownership, and property investment in general, then you’ll want to check out our free guide to building your wealth through property, courtesy of our resident investment expert, Andy Churchill.
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